The international real business cycle when demand matters

Abstract

This study explores the demand side of an international real business cycle model adopting additive intratemporal preferences over differentiated final goods and monopolistic competition. It shows that the structure of the demand system matters for macroeconomic dynamics by affecting firms’ pricing over time and across countries. The endogenous variability of markups and profits amplifies the propagation of shocks through novel substitution effects, generating positive comovements of output, labor and investment, and reducing consumption correlation between countries. In particular, a positive shock in the Home country improves its terms of trade, promotes consumption in the Home country and also production in the Foreign country.